While Congress pressures the Federal Housing Administration to keep expanding its insurance portfolio, the great Joseph Gyourko notes the dangers:
FHA remains dangerously overleveraged at over 30-to-1: It has only about $30 billion in liquid capital to back just over $1 trillion in outstanding insurance guarantees on its single family mortgage portfolio. That is a ridiculously small amount of capital for such a risky business, and a serious government would not allow such overleveraging to continue.
It is worth remembering that FHA’s business model shares key risk traits with the now infamous CDO-squared (collateralized debt obligations-squared or CDO2) securities that were among the first to fail in the recent financial crisis. For those not familiar with those securities, a CDO2 essentially was backed by a pool of high loan-to-value mortgages with little or no home equity cushioning them against losses in the event house prices declined. Because all the loans shared the same weakness (little or no equity cushion), they were all susceptible to any economy-wide shock that lowered house prices or raised unemployment. When house prices fell by a modest amount at the beginning of the crisis, all the loans went underwater, making all of them more likely to default.
Investment professionals call what happened the result of correlated or concentrated risk. The pooling of highly leveraged assets (mortgages in this case) means that a decline in house prices will negatively affect all the assets in the pool, not just a few. There is no diversification of risk with this structure. Indeed, the risk is concentrated. And default risk is positively correlated across the different mortgages in the sense that if one defaults, it is likely that the same fate will befall many others at the same time. Why? Because they share the same weakness (little or no equity), which leaves them susceptible to the same economic shock.
As my Economics 21 colleague Chris Papagianis has argued, congressional Republicans are very much part of the problem. Chris has also offered a starting point for how we might reform the FHA and reduce the risk it poses to taxpayers and the wider economy.